The following is a translation of a directive ("public letter") issued on 30 December 1999 by the German Federal Ministry of Finance to the central tax authorities of the German States. Text in brackets [ ] has been added in limited circumstances to facilitate comprehension and is not part of the German text. Footnotes are translator's comments and likewise not part of the German text.

The translation was prepared by KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany) to assist in gaining general familiarity with the terms of the directive. It is not intended to be a basis for business decisions or to replace in any way the German version, which is the sole official version. KPMG Germany is pleased to provide advice relating to specific situations upon request.

Principles for Review of Income Allocation in Cost Contribution Arrangements Between Internationally Associated Enterprises

Based on the results of the talks held with representatives of the Central Tax Authorities of the German States, the following [guidelines] apply when reviewing income allocation in cost contribution arrangements (CCAs) between internationally associated enterprises:

1. General

The purpose of this directive is to define rules for applying the arm's length principle in cases where internationally associated enterprises have used cost contribution arrangements to structure their relationship to one another. These rules do not apply to direct invoicing of individual services regardless of whether the transfer price is determined using direct or indirect methods.

1.1 Definition

Cost contribution arrangements, as defined herein, are agreements concluded among internationally associated enterprises to obtain or render services in their mutual interest over an extended period of time through participation in a cooperative pool.

The services must be rendered in the interest of the receiving firms, which must expect to derive benefit from them, e.g. in the form of cost savings or increased revenues. The services include support functions of the pool members and are valued in the aggregate or can consist of multiple individual services. Such cost contribution arrangements are based on the concept of a cost pool. The expenditures can relate to all types of services, such as research and development, goods purchasing, management services, or other services. Subject perhaps to certain ceilings, expense incurred in furtherance of the purpose of the pool is divided among the pool members using a cost allocation formula determined in accordance with their [respective] benefit. In this regard, the enterprises form an association inter se without creating a partnership or permanent establishment.

1.2 Pool Members

For taxation purposes, only enterprises which pursue parallel interests can be recognized as a members of a pool, i.e. only those firms which use the pooled services in the same economic manner.

The services are pooled for purposes of jointly purchasing, developing, or manufac-turing goods, services, or rights in order to derive mutual benefit from the pooling of resources and capabilities associated therewith. Thus, participation in a CCA is restricted to enterprises which themselves derive benefit from the services they render to the pool, in other words, which [themselves] make use of the results of the joint activity.

In a research and development pool, holding companies and patent exploitation companies pursue interests different from those of manufacturing companies. They may therefore not join the same research and development pool. This does not prevent them from contracting with a pool to use its results.

Persons contracting with the pool to render services in the interest of its members without themselves using or exploiting the results (mere contractors), are not included in the CCA (see sec. 1.7).

1.3 Cost Contribution Arrangements

In accordance with standard business practice, a cost contribution arrangement must be concluded in advance and in writing, must meet certain minimum requirements, and must be accompanied by appropriate documentation (see sec. 1.5). The terms of the cost contribution arrangement must be adhered to [in fact].

1.4 Services

Except in the case of demand pools (see sec. 1.7), pool services can be provided jointly by one, several, or all members of the pool. Accordingly, no exchange of performances takes place since the allocated costs are treated as originally incurred by the individual pool members.

Enterprises which receive services can be granted a right, defined as to nature and scope, to request services themselves or to issue job orders to the service-providing enterprise.

If the services differ in nature ("unlike services"), each service category must be separately recorded and measured, for instance, when a pool member provides services for a research and development pool along with various types of management services.

1.5 Prohibition on Double Charging

Where costs are invoiced under a CCA, the costs which have been allocated may not be charged to the service recipient a second time, e.g. in the form of a separate charge for goods or services. The performance of the CCA precludes a separate charge for providing intangible economic assets, for providing know-how, or for rendering services to which pool members are entitled under the CCA.

1.6 Asset Capitalization

Capitalization of assets developed under a CCA is precluded by § 5 (2) EStG. Regarding the capitalization of entry fees (buy-in payments), see sec. 4.1.

1.7 Services Rendered by Non-Pool Members

The pool can also obtain its services from an associated enterprise not itself included in the CCA (demand pool), e.g. in the form of contract research. This enterprise's services must be charged to the pool at arm's-length rates (cf. Federal Tax Court judgment of 23 June 1993 - BStBl II 1993, p. 801). If appropriate arm's-length prices are not available, the services must as a rule be priced using the cost-plus method. The amount so charged to the pool is apportioned among the pool members by means of an allocation formula.

Example:

The companies of the M-Group, A, B, and C, each located in a different country, have hitherto each done their own research work. In order to avoid redundant effort and expense, they form a research pool in which the research work is carried out solely by Company A. The costs of A amount to 126. Company B assumes coordination responsibilities since the research pool also obtains research services from Company D, another group company.

Company B's costs are 6; those of Company D are 60.

Companies A, B, C share equally in the results.

A

B

C

D

Total

Costs

Profit mark-up

126

-

6

-

-

-

60

3

192

3

Total

126

6

-

63

195

Cost allocation

65

65

65

-

195

Reimbursement

Payment

61

-

-

59

-

65

63

-

124

124

2. Allocable cost amount

2.1 Determination of Costs

Actual direct and indirect costs which are economically related to the services rendered or to be rendered are the basis for determining the allocable cost amount. The costs are generally to be determined in accordance with the accounting rules of the country where the enterprise rendering the service does business. The non-deductibility of costs allocated to a domestic service recipient is governed by German tax law (e.g. by, § 160 AO and § 4 (5) EStG). The costs must be clearly differentiated. If several pool members render the agreed service, the costs can be determined under the accounting rules of one country or according to the rules governing preparation of a consolidated balance sheet for the enterprises [in question], provided no objections to this approach are raised by the tax authorities in the countries in which the services are rendered.

The costs must be reduced by the earnings (including subsidies and supplements) to which they are economically related. The same applies for tax preferences, such as special depreciation. If intangible assets created in the context of the cost contribution arrangement are licensed by the pool [as licensor], the allocable cost amount is reduced by the amount of the royalty income.

Where pool members provide property or services [to the pool], this shall not constitute an [outright] transfer of any assets so provided, but rather a [temporary] conveyance of their use, the value of which is measured by the expense incurred. For tangible assets which have already been [completely] depreciated, this determination is made based on fair market value at the time of the conveyance and remaining useful life. For intangible assets, it is acceptable to estimate expense by deducting the normal profit component from a reasonable royalty payment.

In determining costs, an interest charge may be included on the equity used in the venture as shown on the tax balance sheet. This is calculated at the deposit interest rate for the currency of the country of business activity.

If costs for unlike services are allocated under a uniform CCA, the costs to be allocated must be determined separately for each service category (see also par. 3 of sec. 1.4).

No benefit offset adjustment is permitted between separate service categories or with respect to other services not subject to the allocation procedure.

2.2 Profit Mark-Up

Without prejudice to par. 4 of sec. 2.1, no profit mark-up on the allocable costs can be allowed for tax purposes in light of the pool's common objective and the lack of entrepreneurial risk for the service-providing enterprise.

3. Allocation process

3.1 Basic Principle

Allocable cost is apportioned on the basis of the benefit which each pool member itself expects to receive. The expected benefit is determined on the basis of business management principles considering all circumstances and developments which are reasonably foreseeable at the time of contracting. The basis on which allocation is to take place and the measure of benefits*[*Translator’s note: In German, Verteilungsmaßstab. Alternative translation, "[cost] allocation factor[s]".] are determined by the parties themselves in accordance with this [principle]. If unlike services are combined in a single CCA, the [expected] benefit must be determined separately for each service.

A prudent and conscientious business manager will not participate in a cost contribution arrangement when it is foreseeable from the start that he can obtain comparable services more easily and cheaply on a direct charge basis. By the same token, a prudent and conscientious business manager will not continue a CCA in its existing form if it is clear after a reasonable time has elapsed that the CCA is less advantageous than individual purchase of comparable services. No account may be taken of non-quantifiable benefits based on membership in the corporate group. The arm's length standard does not rule out tax deductibility for cost contributions to research and development pools which have turned out to be failures. A cost contribution paid on the basis of a CCA is allowable for tax purposes only to the extent that the contribution does not consistently exceed the arm's length price for the services provided. A cost contribution based on a percentage of the service recipient's sales regardless of the specific costs or based on a similar variable will not be allowed for tax purposes.

3.2 Cost Allocation Formula

The taxpayer must choose the cost allocation formula which is most appropriate to the specific case. If several formulas prove to be equally valid, the business manager has discretion in choosing a formula.

Factors meriting consideration as the basis for the measure of benefits include without limitation the following: the number of units in a product line which are used, manufactured, sold, or anticipated; cost of materials, machine hours, number of employees, total wages, value added, capital invested, operating profit, and sales. Other measures may also result from the circumstances of an individual case. For instance, allocation formula using a combination of differently weighted factors may also be appropriate.

3.3 Adjustment

Parties dealing with one another at arm's length would verify after expiration of an appropriate span of time whether actual benefit corresponds to anticipated benefit. The timing of such a review depends on the degree of uncertainty of the assumptions made. Material changes must be reflected by adjusting the contributions, which usually means modifying the measure of benefits. Provided the review takes place on a timely basis, adjustments will apply only to the future.

3.4 Contribution Charging Process

If advance payments are made or if contributions are charged based on budgeted costs (planned figures), final invoicing based on actual costs must occur before the date of signature of the balance sheet for each invoicing year.

4. Special Cases

4.1 Late Entry

Enterprises which join a CCA at a later point in time must pay an entry fee (buy-in payment) if the existing pool members provide the entering member with tangible or intangible results. The entry fees are determined under the arm's length principle. The results [provided] may consist of intangible assets, work in progress, or knowledge generated by the work to date. This means that payments for failed research may also be appropriate. This is the case when a prudent and conscientious business manager would, depending on his perspective, have required or agreed to a payment for the additional knowledge thereby acquired. If the entering firm contributes [to the pool] a level of knowledge approximating that of the previous pool members, no balancing payment is indicated as a rule. In all cases where a balancing payment is made, the previous pool members transfer part of their respective shares of the results stemming from the previous activities. The acquirer must reflect the transaction by entering an asset on his balance sheet.

Paragraph 3 of section 2.1 shall apply analogously in the event the entering enterprise provides performances in kind in lieu of a cash entry payment or for other reasons.

As a rule, no entry fee is indicated if the CCA relates to management services.

4.2 Early Withdrawal, Termination

An arm's length exit fee payable to the remaining members may be appropriate where a pool member withdraws prematurely and is able to derive additional benefit from the results achieved to date (e.g. by licensing or selling them to third parties) or where the member's withdrawal burdens the remaining pool members with additional costs. This will always be the case when the withdrawal leads to an identifiable and quantifiable reduction in the value of the CCA as continued [by the other members], for instance because the remaining pool members provide or assign previously existing rights to intangible assets, work in progress, or know-how generated in the context of the CCA to the withdrawing partner.

Exit fees are generally inappropriate where the CCA's sole purpose is to provide services which the pool members receive jointly and pay for periodically, unless the services involve the creation of assets or rights.

Where the remaining pool members are the sole beneficiaries of the results to date following the withdrawal of a pool member, a balancing payment to the withdraw-ing pool member may be justified. This is always the case where the withdrawing member transfers his pecuniary rights under the CCA to the remaining pool members.

When a CCA is terminated by its participants, each of them is entitled to that share of the pool's results which corresponds to the contributions which were paid to the pool during the term of the contract in the form of entry fees or balancing payments.*

[*Translator’s note: The German is presumably intended as a reminder that account must be taken of entry fees and balancing payments in addition to normal contributions under the cost contribution arrangement. Cf. OECD Guidelines, Ch. VIII, par. 39, which makes a similar statement.]

4.3 System Conversion

Where, in connection with conversion of a CCA to a license agreement, the contracting parties waive their interests in the results of the CCA in favor of the future licensor or licensors, they must receive appropriate compensation for relinquishing such interests.

When a research and development CCA is terminated by its participants and replaced by a license agreement without passage to the licensor of the participants' interests in the results of the CCA, account must be taken of the fact that the previous pool members are able to use the know-how and intangible assets generated, at least during a transition period.

4.4 Withholding Tax

Cost contributions are not subject to withholding tax under § 50a (4) EStG.

Tax withheld on royalties to which the pool members are as such entitled by reason of rights of use licensed to third persons may only be claimed pro rata by each individual pool member. To the extent the entire amount of foreign tax withheld is claimed for tax purposes by a pool member holding formal legal title to the rights to the intangible assets, compensation must be paid to the other pool members.

Where a foreign pool member permits a domestic service-provider pool member to use intangible assets, the compensation owing is subject to withholding if the requirements of § 50a (4) EStG are met. Any offset of the compensation against the cost contribution amount does not affect the imposition of withholding tax.

5. Documentation and Proof

5.1 Documentation

5.1.1 Form and Content

To be recognized for tax purposes, a CCA must be in writing and, together with any attachments, annexes, or supplementary agreements, include the following minimum requirements:

1. Names of the pool members and of other related-party beneficiaries;

2. Exact description of the services forming the subject matter of the contract;

3. Determination of allocable costs, the method of the cost recordation, and any exceptions;

4. Determination of the benefit each participant expects to receive;

5. Determination of the cost allocation formula;

6. Explanation as to how the amount of the pool members' initial and subsequent cost contributions is determined and uniformly charged to all pool members;

7. Nature and scope of invoice controlling (e.g. for advance payments; point of time);

8. Provisions for adjustment to changed circumstances;

9. Contract duration;

10. Provisions regarding contract termination and, if appropriate, the conditions and consequences of the entry of new pool members and the early withdrawal of existing pool members;

11. Stipulations regarding access to the documents and records relating to the cost incurred and services provided by the service-provider enterprise;

12. In the case of research and development, allotment of rights of use arising from the pool's central activities.

5.1.2 Documentation of Costs and Services

The services rendered to the pool members and the related costs must be documented so as to permit verification. This applies in particular when different services are combined into one uniform CCA. If indirect costs are allocated [to the services performed], the basis of such allocation must be documented. Income earned in connection with the CCA must be separately recorded.

5.1.3 Documentation of the Anticipated Benefits

Special significance attaches to the determination of anticipated benefits. The anticipated benefits can be demonstrated by means of problem analysis, project reports, target goals, and similar documentation. The documentation must also show the extent to which other group members may derive benefit from the CCA.

5.1.4 Documentation by the Service Recipient

The service recipient's documentation must include the following:

1. The CCA with attachments, annexes, and supplements;

2. To the extent not contained in the contract or its attachments: documentation substantiating the contributions paid, especially with regard to expected services, anticipated benefits, the cost allocation formula, and the measure of benefits (extent of the benefit in relation to other service recipients; allocation of costs in accordance with their causes and benefits);

5. Documentation of services actually received and benefit derived, e.g. monthly, quarterly, or yearly reports on individual services and projects by the service-provider enterprise, correspondence, visitor reports, minutes of meetings concerning specific projects; research results in report form, lists of patent applications, press write-ups, start of production of new products, improvements or innovations in the manufacture of existing products.

5.2 Substantiation and Evidence

As a basic matter, the CCA can only be used as a basis for income allocation for tax purposes if the documentation requirements have been fulfilled. In accordance with § 90 (2) AO, the tax authorities can require [production of] the information, documents, and evidence which are necessary under the circumstance of the individual case. Upon request by the tax authorities, the service recipient must therefore produce documents from the service provider without delay.

At the taxpayer's request, the tax authority may allow individual terms at variance with the above provided this is appropriate by reason of special circumstances (for instance, in the case of a multilateral CCA or in the absence of specific provisions regulating cost recordation or allocation within the meaning of sec. 2 and 3), provided the domestic [tax] outcome of the CCA does not differ substantially from the result under a contract meeting the requirements of sec. 5.1.1.

6. Deficiencies in a CCA

If a CCA contains serious deficiencies such that a prudent and conscientious business manager would not have become party to the contract, then no deduction of business expenses will be allowed. If a prudent and conscientious business manager would only have become party to the contract provided his payment was smaller, then a deduction of business expenses is permitted only to this extent. The deductible amount is determined by estimation (§ 162 AO). The tax authorities are also permitted to estimate the deductible amount in other cases, for instance, when the cost allocations are not verifiable for want of sufficient documentation. They may base this estimate on facts which appear reasonably probable.

7. Repeal of Tax Regulations

Section 7 of the Principles for Reviewing Income Allocation Between Internationally Associated Enterprises (the Administration Principles) of 23 February 1983 (BStBl. I p. 218) is hereby repealed.

8. Transition Provisions

To the extent the above provisions necessitate adjustments to existing CCAs, these must be completed by 31 December 2000. Otherwise sec. 6 will apply.

For further information, please send a fax or an e-mail stating your inquiry to KPMG Frankfurt, attn. Christian Looks: Fax +49-(0)69-9587-2262, e-mail cLooks@kpmg.com. You may also send an e-mail to KPMG Germany by clicking the Contract Contributor button on this screen.

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